VALUE INVESTING
The Non-Pension Pension

By Stephen Bland (TMFPyad)
April 21, 2005

One of the two strategies I feature in Value Investor is the high yield portfolio (HYP). This is the long-term approach of investing in a limited portfolio of large cap, high income shares, with very little trading occurring. I completed recently the first portfolio of fifteen shares and will shortly be starting a second one.

The idea is attractive to both income investors and growth investors reinvesting dividends, with no cost or problem in switching the portfolio between the two modes. Consequently, it is an ideal equity strategy for a savings and retirement income plan, like a pension scheme but your own non-pension pension, reinvesting dividends and making payments into it during the growth phase, then eventually drawing the dividend income when required.

There are, though, many significant differences between using a HYP in this way and an official pension scheme. I'm referring to entirely self-funded schemes by the way, meaning those self-employed, non-employed or in non-pensionable employment. For those in receipt of employer contributions to a personal pension (PP), then being free it must be worth having in any event. Here's a brief view. All rules are current and can be subject to change over the years.

Tax

A PP scheme attracts tax relief on contributions at the marginal rate of the investor, which means up to 40% for higher rate payers. Investment in your own HYP, whether held in an ISA or direct, gives you no tax break. The effect is that the contributions to a PP are boosted by 66.7% for a higher-rate payer compared with an HYP. You can hold an HYP in a Self-Invested Personal Pension (SIPP). These schemes have the same conditions as insurer run PPs but you choose the investments.

No tax is payable on the income or gains made by a PP during its growth phase. With a HYP, if held in an ISA the same applies. If held outside, then tax could be payable on gains in certain circumstances and is due on dividends received by higher-rate payers.

Upon ultimately drawing the income, the favourable tax situation of PPs reverses in favour of the HYP. PP income is liable to income tax either as an annuity or some kind of drawdown. There is, though, the opportunity to take 25% of the fund as a tax-free lump sum. HYP income from an ISA will be tax free. If held direct, then dividend income is tax free to basic-rate payers and liable to 25% on higher-rate payers, compared with 40% on annuity income.

Put simply, PPs give you tax relief on the way in and tax most of it on the way out. HYPs grant no tax relief on the way in and a nil or lower rate of tax on the way out.

Onerous Impositions

This is where the two approaches are not even on the same planet. A PP including the SIPP version is absolutely riddled with controls, regulations and limitations. In return for the tax relief on the way in, you really have to sell your financial soul to the insurance industry and it will hit your pocket and your freedom with your own money immensely.

A HYP, even if held in an ISA, gives you absolute freedom to invest, withdraw, obtain income and generally do what you want with your own money. Critically, at the retirement phase of your life, you are able to retain the capital whilst drawing your income from it. This is where Value Investor can come in, showing you the construction of a portfolio.

In contrast, PPs cannot return your money to you. Once invested you are committed irrevocably until maturity. Even then, capital withdrawal is limited to a 25% tax-free lump sum. Eventually you are then compelled to take an income from the balance but you will never see that money again, being tied to the income from it for life if it's an annuity, which most are. It will die with you or maybe your spouse if you took a lower rate joint version, leaving nothing to your heirs. Various changes come in next year but they all involve some sort of compulsory income from the fund. And any liberalisation of the income requirement is going to cost, too.

Now look at costs. An HYP costs virtually nothing. You have the usual charges to buy the shares and the very occasional trade perhaps. If it's in an ISA then there will be a charge for that but only maybe £25 per year. Thus the annual charges are as near zero as makes no difference and there's no set-up fee to anyone. The total costs over decades add up to zip.

Compare this with PPs. The much promoted "low cost" stakeholders for example charge up to 1% per year, now expected to rise I understand. Normal PPs cost even more and SIPPs have their charges, too. Apart from charges at the growth phase, it is likely that at maturity all sorts of further charges will appear as you convert from capital to annuity, transfer to another annuity provider, and so on. HYPs convert seamlessly from growth to income with no costs or difficulties.

Conclusion

If you are one of those people who will buy anything just because it has tax relief attached, then no doubt you will find the PP more attractive for that reason despite the seriously onerous restrictions. Or the SIPP version, perhaps, if you are a HYPer that cannot resist tax relief. But it is an old story that to go into an investment just for tax relief is usually a mistake. The relief often disguises something underneath which upon close examination is just too unattractive and without that relief would never be considered at all.

However, if you want total freedom and don't feel that the tax situation of PPs and the rest of the impositions are anywhere near desirable enough to compensate for the loss of that freedom, then I believe that a HYP, as in Value Investor, is for an equity strategy an ideal way to design your own approach to retirement income. And I haven't even mentioned the outperformance and lower risk of HYPs than most other equity strategies, including trackers.

Stephens recommends a high yield share every month in the Value Investor newsletter. For more details on building an income portfolio, click here.